Advanced Modelling in Finance Using Excel and VBA

Chapter 8. Performance Measurement and Attribution

The broad objective of performance measurement is to assess and compare the performance (past returns) of different investment strategies. Our main emphasis in this chapter will be on the choice between passive and active investment strategies when assembling a portfolio of risky assets. The secondary emphasis will be on choosing the level of risk-free assets to complement the chosen risky portfolio.

Under a pure passive investment strategy, an investor holds a portfolio that is an exact copy (by component shares and weights) of the market index. The passive investor does not rely on superior information and, apart from rebalancing when the constituents of the index change, there is no trading. The passive investor is rewarded for bearing market risk and will achieve the market return less the unavoidable trading costs.

In contrast, under an active investment strategy the investor's portfolio differs from the market index by having different weights in some or all of the shares in the market index. The active investor relies on having superior information and is prepared to incur much greater trading costs than the passive investor. In practice, only a few active investors outperform the returns from passive investment in the long term, since they bear specific risk and incur greater trading costs. With the increasing complexity of active strategies, the need for more sophisticated benchmarks and performance measurement is becoming ...